TREND TRADING

December 21, 2016

I still remember “The Comeback”. On January 3, 1993, my team, the Houston Oilers, led by Warren Moon, jumped out to a 35-3 lead over the Buffalo Bills in the AFC Wild Card Game. It was the second straight week they faced each other, as Houston had closed out the regular season the week before with a 27-3 whooping in the Astrodome, in which the Bills’ quarterback, Jim Kelly, left the game with an injury. His replacement, a no-name Frank Reich, was horrible, and I thought Bum Phillips and his boys would waltz into Buffalo the following week and lay the wood to the Bills once more. I think Buffalo fans thought the same thing, as they failed to sell many tickets, leaving the game much less than a sellout, and denying the local Buffalo stations from carrying the game on television.

Houston ran out to a 28-3 lead by half, completely dominating Buffalo. Joining Kelly on the sidelines was the AFC Defensive Player of the Year, linebacker Cornelius Bennett, and their great running back (and Oklahoma State great), Thurman Thomas, who was carted to the locker room with a hip injury early in the game and never returned.

At halftime fans started leaving in droves. The Buffalo radio announcer was quoted as saying, “The lights are on here at Rich Stadium, they’ve been on since this morning, but you can pretty much turn them out on the Bills right now.”

Then Houston opened the third quarter with a pick-six to make it by 35-3. It was over. The fat lady may not have been singing, but she was stepping up to the microphone and clearing her throat. The momentum was like an avalanche coming down on the Bills. I recall Charlie Jones, the great NBC announcer, working so hard to keep everyone’s attention and not be tempted to hit the remote to the other Wild Card game. The cameramen tried to masterfully shoot angles so we couldn’t see all the empty seats.

Then suddenly, but quietly, the momentum shifted. Reich, who a few years earlier as a backup quarterback for the Maryland Terrapins had orchestrated the greatest comeback in college football history over the then #1 ranked Miami Hurricanes (remember “The U”?) by erasing a 31-0 first-half deficit to win 42-40, suddenly caught fire. He threw three touchdown passes in seven minutes against the N.F.L.’s third-best pass defense. When he threw his second touchdown, fans that had left the stadium started trying to get back in. NFL rules didn’t allow reentry once a spectator walked out the gate, but NBC kept showing fans climbing fences around the stadium. After a while security relented and opened the gates, and by overtime the stadium was overflowing well beyond capacity.

Over the final 27 minutes Reich marched the Bills to five unanswered touchdowns and overtime, when Steve Christie hit a 32 yard field goal to end the greatest comeback in NFL history.

Houston just couldn’t stop the Bills’ momentum. Once the flood gates opened, it seemed there was nothing they could do to shut down Buffalo’s second team. Watching it at the time I could sense that something huge was taking place. It’s just the way momentum works. Once it starts, it’s hard to stop.

Just like in sports, momentum plays a large role in other aspects of life, including business, politics, and the stock market. We call it trend, and if used properly, can be a powerful weapon when it comes to investing. Trading stocks in the direction of the trend is like running downhill with a wind at your back. Like floating downstream.

And it’s fairly easy to locate stocks that are trending. Anyone can do it. It’s not hard to plot closing prices of a stock on a sheet of paper to determine if it is trending up or down. The internet provides those charts at the simple touch of a button.

So the obvious question you might ask is that if it’s so easy to locate stocks that are trending, and even easier to ride that trend, then why isn’t everyone doing it? Just find a trending stock, trade it in the direction of that trend, and sit back and count your money, right?

But the fact is most investors don’t make money following trend, and I believe there are two reasons why:

They don’t really believe in it.

The ones who do tend to overstay their welcome and fail to take profit before the trend stops and the momentum shifts

The reality is that the majority of investors don’t believe in trend or momentum when it comes to investing. They invest based on fundamentals only. Don’t get me wrong, fundamentals play a significant role in value and price of a company. But believe it or not, value and price rarely marry in the stock market, much less date. Price in an open market is driven by emotion, and emotion can gain momentum in one direction or another that at times makes absolutely no sense whatsoever. But that emotion, no matter how crazy, must be respected.

After doing this for over 25 years now, I don’t get why so few people believe in trend in the stock market. A business person is not inclined to buy an existing company that has falling sales or fewer and fewer customers. A real estate mogul is rarely interested in purchasing property in an area that is steadily declining in value. A mother doesn’t buy tight fitting clothes for her growing ten year old son. A newly married couple looking to start a family doesn’t buy the one bedroom flat, or the two door sports car. They all consider trend before buying. Then why don’t folks analyze the trend before buying a stock? Even the greatest fundamental investor of our lifetime, the Oracle of Omaha Warren Buffett himself, acknowledges that he studies a stock’s trend before pulling the trigger.

But just taking advantage of trend doesn’t automatically guarantee success on Wall Street. Understanding and embracing momentum is just half the battle, and typically the easiest half.

The reason even the best trend traders struggle to make money is that they tend to overstay their welcome, and unfortunately ride the trend both ways. Most trend traders can ride a stock upward, but they make the mistake of continuing to ride it as it loses energy, reverses course, and moves the other way. It would have been great if the Oilers could have ended their Wild Card game at halftime up three touchdowns. The great news is that in the in the Wall Street game, you can end the game whenever you choose.

All good things do come to an end. Trend eventually swings the other way. Just eight years ago the Democrats were definitely trending higher. But somewhere around 2010 their momentum waned, reversed, and began to go the other way. Subsequent elections shifted to the Republicans, and after the one just ended, they obviously have all the mojo. But I would say they better hurry and do something with it, because one day their momentum will stall once more, and the Dems will likely be back in vogue.

In trading, the trick is to not only recognize and ride the course of a trending stock, but even more importantly, the trick of the trade is to recognize when the music stops, and the momentum turns. That’s when it’s time to take profit, rather than ride what once was a fantastic trade right back down to a break-even, or possibly losing trade.

Here is a crazy example from just the last couple of weeks. After the Trump victory on November 8th, several shipping stocks began trending higher. One in particular, a company called Dry Ships (DRYS), went from $4.46 on November 8th to $5.10 on November 9th, then to $11.90 on November 10th. Over double in price in three short days. Not bad.

But it didn’t stop there. On the 11th the price rose another 20% to $13.60. Then tripled to $43 the next day, and then finally all the way to $100 the next day. That’s a $95.50 gain in just five days, or up over twenty times! Just for fun, let’s say you owned 1,000 shares of the stock in your portfolio on November 8th. Your $4,500 would have been worth $100,000 just five days later. Wow, cha-ching, cha-ching.

More specifically, you would have made $100,000 if you would have sold it.

The same day DRYS hit a high of $100, it suddenly reversed trend, and ended the day at $73. No sweat, right? But the following morning the downward trend continued, and by the close of the day the stock was back down to $11. The sinking momentum carried to the next day, and the following, and the following, and the following, and the following, and the following, until it reached $4.50 once more. The stock went from $4.50 to $100 and back again in just two short weeks.

I read a tweet from a guy who rode the trend in Dry Ships from $5 to $80, where he exited. Another one caught the momentum from $7 to $42. Still another trader actually showed his trade confirmations where he purchased 3,000 shares of the stock on November 9th at an average price of $4.61, and sold those same 3,000 shares on November 15th at $71.42. That was a gain of $200,430 on a $14,000 investment in six days. The force was with him.

But on the twitter feed I was following there were dozens and dozens of traders who rode the stock from $4.50 to $100 and back to $4.50, all while they sat and stared at their computer screens. On November 15th one trader bragged how she was up $840,000 in five days. The problem is she never sold before the trend reversed. Her position is under water, and just a few days ago she finally admitted she made one of the biggest mistakes of her life.

I only purchase stocks when the momentum is pointing higher, and I have the wind at my back. This typically results in consistent returns, as long as I take profit once The Big Mo stops. But I must admit that I don’t always see a trend reversal quickly enough, even when I’m glued to the market every hour it’s open. In today’s Wall Street stocks can move and trends can change in the blink of an eye, just like an AFC Wild Card game.

I’m a decent trend follower. I would say a little better than average stacked up against others who do this for a living. There are plenty of professionals who are better than me at recognizing and riding trending stocks. But the thing that separates me as a trader from many of my colleagues is that over the years I’ve learned to recognize when the trend reverses, and to take immediate and decisive action. I’ve learned to swallow my ego and never fight a trend that suddenly and dramatically turns against me. I’ve been trained at the Wall Street School of Large Losses that it is better to exit a reversing trend as quickly as possible, before the momentum gets carried away and small losses become devastating ones. By adhering to my rules to never try to swim upstream, I’m able to limit losses and preserve capital to fight another day. I’ve personally witnessed better traders than me who have lost fortunes simply because they refused to swallow their pride and get out of an investment that trended against them. A trend can always outlast your money.

If you want to be a successful investor over the long run, I believe you must embrace and follow trend. But even more importantly, you must recognize and respect momentum shifts, when the force is no longer with you. That’s when you must take your lightsaber and transport to another galaxy far, far away, before the evil trend turns against you and the dark forces of the stock market part you from your hard earned money. Sorry, the new Star Wars is coming out.